Central banks determined to keep inflation expectations anchored

• Central banks have become very hawkish in a short space of time
• It's unclear whether we're moving to a high inflation regime
• A recession could be deeper than presumed

After years of implementing ultra-dovish policy, central banks have hiked rates rapidly over the past few months to try to rein in a surge in inflation and prevent a break-out of inflation expectations. In doing so they are acting as if the economy is moving into a high inflation regime, but it remains unclear for now whether this is actually the case. The risk is that their actions will push the economy into recession, in which case they will probably have to cut rates all the way back to zero again.

Central banks have made a big U-turn over the past year

Over the past few months many central banks around the world have taken actions that would have seemed completely unimaginable less than a year ago. Back then, central bank policy was guided by the twin problems of low equilibrium yields and persistently below-target inflation. These problems meant that it was difficult for central banks to push real yields low enough to achieve their inflation targets. They tried to resolve this by making a commitment not to tighten policy until the economy was close to full employment and inflation was on track to moderately overshoot its target for some time. The main idea behind this was to convince the private sector that inflation would be equal to target on average over the long run. If they were successful, this would mean inflation expectationsremained anchored to the target even though actual inflation was consistently below it.

So as recently as Q4 last year, markets and central banks themselves expected virtually no rate hikes in 2022 and only a cautious start to the next hiking cycle in 2023. But the situation has changed dramatically since then. Developed market central banks are clearly in a hurry to move the policy rate into the neutral zone, if not some way beyond it. For example, the Bank of Canada raised its policy rate by 100 bps last week. Meanwhile, the Fed hiked by 75 bps in June and the question now vexing the markets is whether it will hike by another 75 or 100 bps this month. Even the ECB, which is faced with the prospect of recession in the Eurozone, has signalled a high chance of a 50 bps hike in September after an initial 25 bps hike in July. The ECB probably wants to start its hiking cycle with a moderate step in July to see how peripheral bond markets react, but a 50 bps hike this week is still a clear possibility.

Their main motivation has been to prevent a break-out of inflation expectations

The initial reason that most central banks became more hawkish relative to the guidance they gave last year was the need to cool down a somewhat overheating economy. In many Anglo-Saxon economies such as the US and UK there was certainly some justification for this as demand for labour was exceeding supply and wage growth had accelerated. Since then, however, growth has weakened due to a decline in real income growth induced by the sharp rise in inflation and increased uncertainty weighing on private sector confidence. The sharp tightening of financial conditions is also likely to weigh on growth going forward. As a result, US labour demand is already showing signs of topping out and wage growth has decelerated somewhat.

In view of all this there seemed to be no reason for central banks to become more hawkish relative to the near-term guidance they gave in May. Roughly speaking, this guidance was for two consecutive 50 bps hikes for the Fed and two consecutive 25 bps hikes for the ECB. But in June, many developed market central banks decided to turn up the hawkish volume a few notches further. To understand this decision we have to bear in mind that the overriding objective of central banks is to keep inflation expectations anchored. Until a year ago, this meant central banks were ultra-dovish, but now it is a reason for them to be ultra-hawkish. In other words, the June hawkish pivot should be viewed as central banks taking out additional insurance against the risk of inflation expectations breaking out to the upside.

Are we moving towards a high-inflation regime?

Central banks will have paid attention to an excellent statistical analysis by the Bank for International Settlements (BIS) on inflation (II. Inflation: a look under the hood (bis.org)), which states that measured inflation rates as they are reported each month are driven by two factors:

• Relative price changes induced by shifts in demand and supply at the micro and sector levels. These serve as very important signals in a market economy.

• Underlying inflation, which can be seen as the common trend in the price changes of individual goods and services. As such it can be seen as the pace at which the purchasing power of money declines.

The BIS distinguishes between two inflation regimes. In a low inflation regime, measured inflation is dominated by relative price changes that dampen out of their own accord. Underlying inflation is not really a factor in price and wage-setting decisions in this regime. By contrast in a high inflation regime, underlying inflation is the overriding factor driving inflation and there is a correspondingly reduced focus on market- or sector-specific circumstances in wage and price setting. A high inflation regime thus blunts the signals sent by the price mechanism, reducing efficiency.

The BIS shows that high and low inflation regimes can be clearly distinguished from a statistical perspective. In the low inflation regime the correlation between individual price changes in the consumer price inflation basket is low, but that correlation increases significantly in the high inflation regime. This finding is to a large extent based on what happened during the Great Inflation of the 1970s. However, over the past year the correlation between individual price changes has clearly increased, raising the question whether developed economies are transitioning to a high inflation regime once again.

Unfortunately it is impossible to answer this question with any degree of certainty. The current inflation spike is little more than a year old and the broadening of inflationary pressures has been going on for less than a year. This means we do not yet have enough data to answer the question from a statistical perspective. It’s also important to note that there is an alternative explanation for the increase in the correlation between individual price changes: supply bottlenecks were and still are an issue in many corners of the output and labour markets. As a result, we can expect upwards pressure on many prices until the bottlenecks are resolved.

What’s more, past experience shows that a one-off increase in the prices of key inputs such as commodities or a large one-off change in the exchange rate can take some time to work their way through the system. While they are doing so, all kinds of measures of underlying inflation, such as core inflation and trimmed mean inflation, will rise before falling back once the shock has been absorbed. For instance, sterling’s sizeable depreciation in 2016 caused a 3.5 percentage point rise in UK trimmed mean inflation that abated after two or three years.

Central banks thus face two competing hypotheses: the current inflation spike might be being driven by large and widespread relative price changes, or there could be a genuine increase in underlying inflation. Of course, it could also be a combination of the two: relative price changes may have been the chief initial cause of the inflation spike but because the inflation spike has lasted longer than anticipated, underlying inflation may have started to pick up as well. The presumed mechanism is a change in inflationary psychology: workers and businesses have hardly bothered about inflation over the past few decades, but observing large and widespread price changes for some time may cause them to anticipate higher underlying inflation in the future.

In fact, it’s a non-negligible possibility that such a self-fulfilling increase in inflation expectations is happening right now. We are clearly in the midst of an economic regime shift and it is still unclear what the new equilibrium will look like. On the other hand, there are two important factors that suggest the current inflation spike will not lead to a replay of the 1970s. The first is that market-based longer-term inflation expectations have declined over the past two months, suggesting that inflation expectations remain firmly anchored. The same applies to longer-term survey-based inflation expectations.

The second is that the institutional environment is very different today from 50 years ago. The Great Inflation became great because of a power struggle between workers and businesses over their respective shares of the economic pie, which triggered a persistent wage-price spiral. For some time, central bankers did not punish the two groups convincingly or persistently enough by triggering lower demand and higher unemployment. This meant the power struggle was allowed to fester. Since then, workers’ bargaining power has fallen substantially, which is probably why there is no real evidence of a wage-price spiral at present: workers’ lot has worsened substantially due to the spike in inflation, whereas businesses have been able to protect their profits. On top of that, central banks are sending a strong signal that they will do whatever it takes to keep inflation expectations anchored.

Conclusion

The practical implication of this strong signal is that central banks will act as if the economy is moving towards a high inflation regime until there is clear proof that this is not the case. In other words, they will continue to hike until there is clear and broad-based evidence that inflationary momentum has fallen significantly. The cost of taking out such insurance against the tail risk of a transition to a high inflation regime is that it increases the chance that central banks will end up tightening too much and push the economy into recession.

In fact this cost could turn out to be bigger than generally assumed. Over the past few decades, recessions and financial panics have been relatively short-lived because policymakers acted quickly to short-circuit any damaging feedback loops. In the real economy, one of the main feedback loops in this respect is the relationship between falling spending and income. In the financial system, such a feedback loop can take the form of debt deflation: falling asset prices cause a widespread increase in leverage, which forces additional asset sales.

The reason policymakers were able to short-circuit these damaging feedback loops early on is that the economy was in a low inflation / low sovereign yield equilibrium. Pre-emptive easing in the face of downside risks was thus very much in the interest of maintaining price stability, and all the more so because the room for additional monetary easing was limited. But the current situation is completely different: central banks are firmly focused on mitigating upside inflation risks, and this severely reduces their willingness to respond to a slowdown in growth or a sharp tightening of financial conditions. As a result, there is more scope for detrimental feedback loops to inflict damage on the real economy. Combined with the possibility of another sharp rise in commodity prices and other supply shocks, this means a recession could be deeper than generally assumed. If this is indeed the case, central banks may eventually cut rates again, potentially all the way back to zero.

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